Spain or Italy: which one is worse off? Economically, Spain; politically, Italy. But since a bad political situation tends to hurt the economy, and a sick economy always poisons politics, the answer could easily be reversed. The political situation in Spain may deteriorate, and the economic edge that Italy now enjoys over Spain may quickly vanish. In any case, what matters is that both nations are doing poorly, and their situation is highly volatile. Now the emergency is to bail out Spanish banks, but not long ago it was the real possibility that Italy might lose its access to international financing -- a threat that had previously alarmed Spain. Before that, was the political crisis in Italy, which paralyzed the government and eventually led to the replacement of Silvio Berlusconi by Mario Monti. So the emergencies hop from one country to the other in fits and starts that make predictability and stability remote memories. It is prudent to assume that the emergencies and surprises will continue, as long as no Europe-wide economic policy framework appears, that would be socially tolerable, financially credible and sustainable in time.

In any case, the country that has now entered the intensive care unit of the financial hospital is Spain. The illnesses afflicting this patient are the result of 15 years of bad habits, and the reluctance to change a reckless economic lifestyle. As we know, there is nothing better than surviving a heart attack to stop smoking, eat more salads and exercise more. It is now obvious that if Spain had adopted a few years back the reforms that it is now putting in place much grief would have been spared. Even now, the country is still reacting with half-measures and reluctantly. The good news is that it has finally began to shed some of its bad habits -- such as, for example, hiding from the public the toxic bank portfolios accumulated during a decade or more by politicians masquerading as bankers and running their institutions to the ground.

But none of this will be enough to restore the patient's health. To bring back long-term stability and put him on the road to prosperity, Spain will need to make deeper structural changes. Uri Dadush, an economist at the Carnegie Endowment, stresses that the roots of the European crisis are not fiscal or financial. They result from the continuous loss of the international competitiveness, especially in relation to Germany, that Spain, Italy and others in Europe's periphery have suffered for more than a decade. Dadush calculates that between 1997 and 2007, the real exchange rate rose in Spain by 11 percent, and by nine percent in Italy (this means that their exports rose in price, respectively, by these proportions). Meanwhile in Germany, in the same period, the equivalent rate fell by 14 percent (that is, the prices of its exports fell in that proportion). Inevitably, this caused Spanish and Italian exports to decline and those of Germany to grow. In the decade preceding the crisis, Spain's total exports (expressed as a proportion of the total economy) fell by 3.4 percent and Italy's by one percent, while those of Germany rose by a whopping 20 percent.

In spite of this, the Spanish economy grew twice as fast as that of Italy -- an economic expansion essentially driven by the construction sector. In Spain, the size of this sector went from four percent of the economy in 1995 to twelve percent in 2007. In Italy, it went from four to six percent. This, in part, explains why the Spanish banks are weaker than the Italian ones as the former are holding a mountain of bad real estate loans.

To get out of their rut, Spain and Italy have to seek new sources of economic growth. And these can only come from a private sector more able to compete in world markets. This, and not fiscal austerity or financial acrobatics, is what will ensure that the patient doesn't need to be regularly taken to the intensive care unit.

About the International Economics Program

The Carnegie International Economics Program monitors and analyzes short- and long-term trends in the global economy, including macroeconomic developments, trade, commodities, and capital flows, drawing out their policy implications. The current focus of the program is the global financial crisis and its related policy issues. The program also examines the ramifications of the rising weight of developing countries in the global economy among other areas of research.

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